Decisions can often turn out to be of two kinds - the right one;and the one your boss wants you to make. The twain do not always meet. Duvvuri Subbarao, the governor of the Reserve Bank of India (RBI), earlier this week, showed us what a right decision is. He decided to hold the repo rate at 8 per cent. The repo rate is the interest rate at which the RBI lends to banks. There was great pressure on the RBI governor to cut the repo rate, after India's gross domestic product (GDP) growth for the period between January and March 2012 came in at a very low 5. 3 per cent. The finance minister, Pranab Mukherjee, declared that he was "confident that they (the RBI) will adjust the monetary policy, " which basically meant that he was ordering the RBI to cut the repo rate.

The idea was that once the RBI cut the repo rate, banks would also cut interest rates, and this would lead to consumers borrowing more to buy homes, cars and durables. Businesses would also borrow more to expand and in turn push up economic growth.

But economic theory and practice are not always in line. Subbarao probably understands this much better than others, though until very recently he had largely stuck to doing what his boss, the finance minister, wanted him to do.
By cutting the repo rate, the Reserve Bank essentially tries to send out a signal to banks that it expects interest rates to come down in the days to come. If banks think the signal is credible enough, they then cut the interest rates they pay on their deposits, as well as the interest rates they charge on their long term loans like home loans, car loans and loans to businesses. But the trouble is that even if the RBI cuts the repo rate, the credibility of the signal would be under doubt, and banks wouldn't be able to cut interest rates.

During the six-month period from December 2, 2011 to June 1, 2012, banks have given loans amounting to Rs 4, 46, 563 crore and have borrowed Rs 4, 27, 709 crore. Hence for every Rs 100 that the banks have borrowed they have lent out Rs 104, which means they have not been able to raise enough deposits to match their loans. Their ability to cut interest rates is then limited. So why then is the money situation so tight?

A very high fiscal deficit, which the government of India has been running, may provide some answers. For the financial year 2007-2008, the fiscal deficit stood at Rs 1, 26, 912 crore. It shot up to Rs 5, 21, 980 crore for 2011-2012 - an increase of 312 per cent in five years. And the income earned by the government has gone up by only 36 per cent, to Rs 7, 96, 740 crore, during the same period. The huge increase in the deficit has primarily been caused by the subsidies doled out on food, fertilisers and petroleum. For the current financial year, the fiscal deficit is projected to be at Rs 5, 13, 590 crore, which is likely to be exceeded - as has been the case in the last few years. The oil subsidy targets have also regularly been overshot. This year, the government might even overshoot its food subsidy target of Rs 75, 000 crore.

The government finances its fiscal deficit by borrowing. When a government borrows more, as has been the case for the last few years, it 'crowds out' the other big borrowers like banks and corporations. This means that the 'pool of money' from which banks and companies have to borrow comes down. Hence, they have to offer a higher rate of interest. This is the situation which prevails now. So banks will continue in the high interest rate mode.

Subbarao's decision would also have been influenced by the high inflation rate which prevails. Consumer price inflation for May stood at 10. 36 per cent. This is likely to go up even further given that the government recently increased the minimum support price (MSP) on kharif crops from anywhere between 15 and 53 per cent. These are crops which are typically sown around this time of the year for harvesting after the rains. The MSP for paddy (rice) has been increased from Rs 1, 080 per quintal to Rs 1, 250 per quintal. Other major products like bajra, ragi, jowar, soybean etc, have seen similar increases. This will further fuel food inflation. Also, after dramatically increasing prices for kharif crops, the government will have to follow up the same for rabi crops like wheat. Rabi crops are planted in the winter season and harvested in March-April. Economists expect higher MSP on agriculture products to push up the food subsidy bill by Rs 40, 000 crore from its current level of Rs 75, 000 crore. This means a higher fiscal deficit and in turn higher interest rates.

In a scenario where inflation is over 10 per cent, cutting interest rates can fuel further inflation. The RBI in a release said that the inflation is 'driven mainly by food and fuel prices. ' That's something Subbarao can do precious little about. The government needs to sort that one out.


The writer is a Mumbai-based journalist